Can carbon emission trading markets reduce the risks in traditional energy markets?

Abstract

As the largest energy consumer in the world, China maintains a tightly interconnected energy market in the international arena. Therefore, it is necessary to explore the interdependence and spillover effects between the carbon emissions trading markets, traditional energy markets in China, and International markets. We explore changes in risk in the Chinese energy market with the introduction of the Chinese carbon market by employing the Vine Copula function to construct a vine structure and analyse the complex interdependence among markets. Moreover, we utilise the Time-Varying Parameter Vector Auto Regression and Diebold-Yilmaz Spillover Index (TVP-VAR-DY) method to examine the dynamic spillover effects of risk across various markets. Empirical analyses reveal a strong interdependence between the carbon emissions trading market and the traditional energy market. The Brent crude oil market occupies a central position within the system and significantly influences other markets. The carbon emissions trading market on the periphery has little impact on the system. Additionally, significant volatility spillover effects—observed between the carbon emissions trading market and traditional energy market systems—are closely correlated with economic conditions and extreme events, demonstrating time-varying characteristics. Furthermore, the Chinese carbon emissions trading market effectively reduces risk spillover in traditional Chinese energy markets from international markets during periods of risk contagion, particularly during times of high volatility, which can offer policymakers a novel path for risk management and provide investors with new avenues for investment hedging strategies.